Inherited Annuity: Everything You Need to Know
- You've inherited an annuity — now what? Learn what you can do with an inherited annuity as a spousal or non-spousal beneficiary and what factors to consider.
If you've recently inherited an annuity, you may be wondering what to do with it. Your options for keeping or cashing out an inherited annuity depend on the contract and your relationship to the deceased. Understanding the tax implications of various options can help you make the best decision for your financial circumstances.
What Should I Do With an Inherited Annuity?
If you inherited an annuity from your spouse, many contracts contain spousal continuance clauses that let you assume ownership and keep the annuity intact. This option is usually preferable because it lets you leave the annuity to new beneficiaries and defer tax payments. Otherwise, withdrawing the annuity in a lump sum could push you into a higher tax bracket and affect your income tax liability.
However, there are often several other options if you need access to the funds or don't qualify for spousal continuance — either because you aren't the deceased person's spouse or the contract doesn't include a spousal continuance clause. Options vary depending on the type of annuity and the contract terms, but they can include the following:
- Lump sum: Withdrawing the entire amount as a lump sum and paying any associated income tax
- 5-Year: Withdrawing the funds gradually over five years and paying income tax on each withdrawal
- Nonqualified stretch: Spreading payouts and tax payments over your expected lifetime
You can also withdraw the funds as a lump sum and invest them in a new annuity, which could be a good option if spousal continuance doesn't apply. Some annuities offer premium or first-year interest rate bonuses, which could help you recover some income tax paid on withdrawing the funds.
If you're eligible for spousal continuance, it's worth comparing the income tax implications of withdrawing the funds to the fees involved in maintaining the annuity. The size of the inherited annuity, your age and your financial situation may also affect your decision.
How Are Inherited Annuities Taxed?
All inherited annuities are subject to income tax, but the rules vary depending on the type of annuity. The most important factor to understand is the difference between a qualified and nonqualified annuity.
- Qualified annuity: Purchased using pretax dollars, such as through a 401k account
- Nonqualified annuity: Purchased using after-tax dollars
If you inherit a qualified annuity, you are liable to pay income tax on the entire amount. You must pay income tax on any withdrawals in the same tax year. Meanwhile, you only pay income tax on the earnings portion of a nonqualified annuity. In other words, you're only liable to pay income tax on any interest earned, and you pay nothing on deposits made by the deceased.
How much income tax you pay on withdrawals from an inherited annuity depends on your relationship to the deceased person. Generally, surviving spouses pay lower rates than other relatives and unrelated individuals.
Do I Have to Pay to Cash Out an Inherited Annuity?
Aside from income tax, you may have to pay fees to withdraw from an inherited annuity. Whether you pay fees, and how much, depends on the annuity contract terms.
Some providers also charge penalties if you fail to make withdrawals according to your chosen payout plan. For example, if you select the 5-year payout option, you may forfeit some funds if you don't make withdrawals totaling the entire amount within 5 years.
If you become the annuity owner due to spousal continuance, the Internal Revenue Service (IRS) will charge a 10% penalty if you make withdrawals before age 59 1/2. Furthermore, issuers usually charge surrender fees if you withdraw during the accumulation phase. The accumulation phase is the period specified in the annuity contract when the funds earn interest and usually lasts between 4 and 8 years. Surrender charges for withdrawing funds can often exceed 5% and gradually decrease toward the end of the accumulation phase.
Can I Transfer an Inherited Annuity?
Some providers allow non-spousal beneficiaries to transfer the funds into a new annuity. The advantage of doing so is that you can defer paying tax on the entire amount. You'll only pay income tax when you withdraw from the new annuity.
Another potential benefit of transferring an inherited annuity is that it will continue accumulating interest, which can significantly increase its value over long periods. You can leave the new annuity to one or more beneficiaries by naming them in your contract.